Managing Cash Flow for Small Business Owners

Cash flow is the lifeblood of any business. It represents the movement of money in and out of the business, which is essential for day-to-day operations. For small business owners, managing cash flow effectively can mean the difference between thriving and struggling to stay afloat. While revenue generation and profit margins are important, even the most profitable businesses can fail if they do not have enough cash on hand to cover expenses. Positive cash flow ensures that a business meets its obligations and sustains itself, while negative cash flow can lead to financial difficulties. In this article we will go over practical strategies to help small business owners master cash flow management.

Understand Cash Flow Basics

Understanding the basics of cash flow is essential for managing a successful business. Cash flow refers to the movement of money in and out of a business over a specific period. It focuses on liquidity or how much cash is available to cover expenses, pay employees, and invest in the growth of a business. Even if a company is profitable, poor cash flow management can lead to difficulties in meeting short-term obligations.

Profit, also known as net income, is the financial gain a business achieves when its revenue exceeds its expenses over a certain period. It is calculated using accounting principles and may include non-cash items like depreciation or expenses incurred but unpaid like accrued interest expense or accrued payroll. It is important to understand the difference between positive cash flow and profit. For example, a business may show a profit because it sells goods on credit for an amount that exceeds expenses, but if those customers have not yet paid, the business might face cash flow issues. Conversely, a company could have positive cash flow from receiving a loan or collecting on outstanding receivables but still report a loss if its expenses exceed revenue. In short, cash flow measures liquidity, while profit measures financial performance. Both are crucial for understanding a company’s overall financial health.

Cash flow can be categorized into two principal areas: Inflows of cash which include receipt of cash from sales, financing activities like loans and equity contributions from owners; and outflows of cash like payment of expenses, purchase of assets, and repayment of debt. Positive cash flow occurs when the inflows exceed the outflows, enabling the business to cover expenses, invest in growth, and maintain a financial cushion. Negative cash flow, on the other hand, indicates that the business is spending more money than it is generating, which can lead to financial strain if not addressed. By regularly monitoring and analyzing cash flow, business owners can make informed decisions, plan for the future, and ensure their operations remain sustainable.

Create a Cash Flow Forecast

To effectively manage cash flow, start by setting up a cash flow forecast using a spreadsheet. There is specialized software to help you manage cash flow, but it can be expensive if you are just starting out and may not be easily configured to fit your needs. Also, your accounting software may not have the functionality to manage your cash flow but can provide valuable reports to help you with your cash flow forecast. A cash flow forecast helps predict future cash inflows and outflows, enabling you to anticipate shortfalls and take corrective action before they occur. To create a forecast from the top down, choose a period to track your cash inflows and outflows. Consider using the end of each week or on each payroll date as your period. For example, if your payroll is semi-monthly, create a spreadsheet that forecasts cash balance every 15th and last day of the month. This allows you to see your cash position on the day of one of your largest outflows, payroll. Next, you will want to decide how to list your revenue. For a professional services company, you can choose to list revenue by customer, project, or type of service. For product-based businesses you might want to consider location or product type. Once you have selected how sales will be listed, do a sales projection. Every company is different, so you will need to rely on either past performance, your budget, actual signed statements of work or a combination of all the above. Timing of cash inflows is important. You will need to estimate the timing of accounts receivable payments and other expected income sources. Update your inflows forecast regularly to reflect changing circumstances and ensure it remains accurate. Expect to spend at least 75% of your time on this section alone since cash inflows can be less predictable than outflows.

Next, list your employees and yourself if you collect a salary. Enter each employee’s gross salary to be paid over the period selected. By listing each employee individually, it will make it easier to add new hires and remove former employees from your forecast. After employees, list all the expenses you wish to track. I like to see all my expenses, so I listed every expense instead of grouping the remainder of the expenses into one operating expense account. I found it easier to decide which expenses to cut or reduce, and which expenses were trending higher than others. It also helps you to decide which expense payment can be pushed out to better manage your cash.

Finally, list all your financing activities such as loans, credit cards and equity contributions. This section will show all inflows and outflows from your financing activities. If you use credit cards to pay expenses, you only need to list the credit card balance. The expenses paid by credit cards should be listed above under expenses. Outflows should be updated regularly to ensure accuracy.

Once you have reached the end of a period on your cash flow forecast, replace the forecasted numbers with the actual cash inflows and outflows for that period. You will need to rely on our accounting software to complete this step. Reports you will need to generate include an income statement on a cash basis for the period completed, cash flow statement on a cash basis and balance sheet on a cash basis. The accounts listed on the income statement and balance sheet should match the accounts listed on your cash flow forecast. Once you have entered the actual inflows and outflows for the period, confirm the cash balance at the bottom of your forecast matches your actual cash balance in your accounting software cash balance and bank statements.

Accelerate Inflows and Delay Outflows

To maintain a healthy cash flow, your goal should be to speed up cash inflows while delaying cash outflows where possible. Here is how:

• Promptly Invoice: Send invoices immediately after providing goods or services and consider offering discounts for early payments.

• Negotiate Payment Terms: Work with suppliers to extend payment deadlines or secure flexible terms without incurring penalties. Negotiate favorable terms with customers. Large customers typically require longer payment terms of sixty plus days, but nothing is written in stone. If you cannot negotiate better payment terms with customers, break-up services delivered into milestones to increase the frequency of invoices. Consider offering a wide choice of payment methods to optimize cash inflow.

• Prioritize Receivables: A week before an invoice is due, send a gentle reminder that the invoice due date is approaching. Follow up on overdue invoices promptly and consistently. Send a thank you note for prompt payments.

Eliminate or Avoid Unnecessary Expenses

This is an obvious step you can take to minimize cash outflow while also helping to improve operating margins without increasing sales. Look for redundancy within your operating expenses such as software subscriptions, employee roles and responsibilities, overstocking inventory and purchasing duplicate or unnecessary supplies, utilities such as phone lines, overlapping business insurance, duplicating website hosting plans, paying employees for standard mileage in addition to fuel expense, and unnecessary industry associations or professional memberships.

Maintain a Cash Reserve

Unexpected expenses can disrupt your cash flow and jeopardize your operations. Establishing an emergency fund for your business can provide a financial buffer. Aim to save enough to cover at least three to six months’ worth of operating expenses.

Manage Inventory Efficiently

For product-based businesses, excess inventory ties up cash that can be used elsewhere. Conduct regular inventory audits to identify slow-moving or obsolete items and adjust purchasing patterns accordingly. Investing in inventory management software can optimize stock levels and prevent overordering.

Plan for Seasonality

Many businesses experience seasonal fluctuations in cash flow. If your business has busy and slow periods, plan accordingly by saving during high revenue months to cover expenses during lean times. Diversifying your revenue streams can also help mitigate the impact of seasonality.

Monitor Key Performance Indicators

Keeping an eye on critical financial metrics can help you stay on top of your cash flow. Key indicators include:

• Operating Cash Flow: Operating cash flow (OCF) is a prominent item on the cash flow statement. Also referred to as Cash from Operations, it measures the cash flow from the business but excludes cash flow from financing and investing.

OCF = Net Income + non-cash expenses +/- changes in net working capital

• Free Cash Flow: Free cash flow (FCF) shows how much money is available after deducting capital expenditures from operating cash flow. It is a more complete picture of a company’s actual liquidity by measuring the cash available for distributions, reduction of debt or paying for growth.

Free Cash Flow = Operating Cash Flow – Capital Expenditures

• Working Capital Ratio: Working capital is the difference between a business’s current assets and its current liabilities. Dividing current assets by current liabilities gives the working capital ratio (WCR). It is a good indicator of the health of a business’s short-term finances.

WCR = Current Assets / Current Liabilities

• Days Sales Outstanding (DSO): Measures the average number of days it takes a business to collect its accounts receivable from its customers. A short DSO indicates that collections are quick and efficient, thus providing necessary liquidity for operations. A long DSO indicates that collections are slow and may limit the availability of cash flow for operations.

DSO = Accounts Receivable x number of days in period / total credit sales

• Days Payable Outstanding (DPO): Measures the average number of days a business takes to pay its suppliers. A short DPO indicates that the business is paying invoices quickly. This could be due to taking advantage of early payment discounts, but it could also mean inefficient use of cash. A long DPO indicates that the business is taking a longer time to pay its bills, which is favorable for managing cash since it increases the company’s cash availability.

DPO = Accounts Payable x number of days in measurement period / Cost of Goods Sold

• Cash Conversion Cycle (CCC): The CCC shows the number of days a business takes to convert its cash into inventory, and inventory back into cash. It is a measure of the business’s cash flow management strategy that factors in purchasing, management of inventory, sales, and collections. The shorter the CCC, the less time cash is tied up in inventory and more of it available for operations and growth. CCC is calculated by using DSO, DPO and Days Inventory Outstanding (DIO). DIO measures the average number of days that a business holds inventory before turning it into sales.

DIO = average inventory during the period / Cost of Goods Sold x number of days

CCC = DIO + DSO – DPO

Regularly reviewing these metrics will help you identify trends and make informed decisions. Good targets for each metric will vary from industry to industry. Further research on your industry’s target metrics may be required to gauge the performance of your specific business.

Seek Professional Advice

If managing cash flow becomes overwhelming, do not hesitate to seek help from financial experts such as accountants or business consultants. They can provide tailored advice, assist with budgeting, and recommend strategies to optimize your cash flow.

Conclusion

Effective cash flow management is essential for the long-term success of any small business. By staying proactive, consistent, using tools and forecasts, and maintaining a cash reserve, entrepreneurs can navigate financial challenges and focus on growing their businesses. Remember, cash flow is not just about survival, it is about positioning your business for sustained success.